Working capital denotes the amount of current assets required by a firm to achieve the required sales target for the year. It refers to the amount of money available for a firm to conduct its day to day activities.
The commonly used method to calculate working capital requirement is the percentage of sales method.
To calculate how much working capital is required, we always consider the projected sales and not the previous year sales.
First we calculate how much percentage of sales is the projected raw material consumption.
Then we calculate the cost of production or cost of sales. In the absence of opening and closing inventory, cost of production and cost of sales are taken at the same level. The cost of production will include raw material consumption, direct expenses and other manufacturing expenses.
Next, calculate the amount of wages/direct expenses and fixed overheads as a percentage of projected sales.
To calculate the raw material storage period, divide the annual raw material consumption by 12 and then multiply the result with the required months of storage.
The conversion period denotes how many days its will take to convert the raw materials in holding to finished goods. When cost of production and cost of sales are at the same level, both stock in process and finished goods are calculated with respect to cost of production.
To calculate stock in process, divide the cost of production is divided by 12 and then the result is multiplied by the time taken, in months, for conversion.
Same procedure is followed for calculating the amount of finished goods as well.
To determine the amount of debtors, divide the projected annual sale by 12 and then multiply the result with the credit allowed to buyers.
The sum of all these along with cash in hand/bank will give the total working capital required for the firm.
To determine how this working capital will be financed, first we determine the contribution from creditors, by dividing the annual raw material consumption by 12 and then multiplying the result with credit available from suppliers, in months. The credit available on expenses is also calculated for the same period.
The working capital gap is then financed through net working capital (i.e. margin on working capital) and bank limit.
The operating cycle period consist of the raw material storage period, the conversion period, the finished goods holding period and the credit allowed to buyers.
If the operating cycle period is greater than 3 months, the Turnover method cannot be used for calculating the bank limit.